August 8th, 2012; China Gold

Kevin: David, we are just getting to the tail end of your travels in Asia. As we talked about before, you are completing the DVD for the Asian block of that series. We have taken the time to talk to Minxin Pei, Martin Jaques, and Stephen Roach. We have looked at Asia from various expert points of view. How have your views changed in reference to what some of these guys have been saying?

David: I think, reinforced, is the main concept that, while China has tremendous potential, they also have a tremendous number of hoops to jump through to realize that potential, and as Stephen Roach has said, you certainly don’t want to underestimate the work ethic of the Chinese. What we have been able to do over the last several weeks is to measure out the challenges that they face. While they have a very clear economic road map ahead of them, what is very unclear is whether or not they have the will to implement the political reforms that will open up the possibility of true economic reforms, taking them into a new era of growth and prosperity.

The old growth model has worked considerably in terms of this industrialization period. The last 30 years has been a magical transformation there in China, much of it wrought by the will and hard work of the common person, but now, what will have to change is not just more common people doing their bit, but it is the leadership which is going to have to reform.

Kevin: One of the things that struck me as unusual and very different about what your experience was with Asia, versus Europe, or here in America, is the availability and the desire for gold. You talked about being able to, right in the airport, change your currency for gold, and in my last conversation with you, you were talking about the huge amount of jewelry and gold availability in Hong Kong.

David: And what is fascinating is the difference from one country to another, one city to another. When I look at Hong Kong versus Singapore, Singapore is like one giant shopping center versus the sweat shop of Hong Kong, if you will, with the financial district smack dab in the middle of it. But Hong Kong is this very frenetically paced, slightly less friendly place because of the pace, which is somewhat reminiscent of a Manhattan or a London in that regard, where people just keep their noses down and drive toward wherever they are going, or walk toward wherever they are going.

One of the unique things about Hong Kong, in contrast to Singapore, even Beijing, and I would assume, Shanghai, as well, is that Hong Kong is really the gold nexus in terms of retail purchases. I would say that there are as many gold and jewelry outlets in that one city as there are in every city in the United States combined.

It is really fascinating because my wife and I spent a lot of time walking through the city, all over, in the new territories, Kowloon and the central district, and the number of jewelry shops, which of course, my wife was appreciating – the availability, the plentitude, the opportunities if you will – the scale was off the charts, not only in the total number of these outlets, but in terms of the number of people in every one of them.

I think of the jewelry shops that I have seen in Chicago, or San Francisco, or New York, or other places, big cities in the United States, and I think that there is an occasional person that walks in for a small little ring or a small little bracelet, and you don’t see a lot of traffic, even in a place like Manhattan, through jewelry shops, and it is so different in Hong Kong. I just was absolutely floored by the busyness, and people were walking out with bags. It wasn’t just window shopping.

Again, it is the kind of thing where I would not have appreciated that had I not been in the city and walked street by street, corner by corner, and just been blown away, from a physical observation standpoint.

Kevin: I would think that may be showing us two things. One is that the prosperity that is coming into Hong Kong is being spent on jewelry, but the other thing is, and this takes me back to the Stephen Roach interview from a couple of years ago when he talked about this being a society with no social safety net, they don’t have retirement that they are paying into that some day, supposedly, will pay back to them. They are having to save for their own retirement. The savings rate, when Stephen Roach interviewed with us, was 37%. That is what the Chinese were saving at that time. Obviously, a lot of that savings is going into gold and gold jewelry. Would you say that those are the two components that create the traffic in those shops?

David: It was interesting, just talking to the people that we were dealing with, both the film crews, and our drivers, and asking them from a family perspective, how they viewed gold. It was funny, because it was not like they had an opinion, as if they’d thought about it, it was just something that they assumed as very basic to what they did with a part of their money.

One response, in particular, was, “Well, you certainly don’t want all your money in the bank do you?” This was just a candid conversation with someone who was not particularly informed in matters of finance or investment, not necessarily a thoughtful process, but one that is societally assumed – “You can’t have all of your savings at the bank. You wouldn’t want to do something like that, would you?” It is an interesting cultural phenomenon, to see the demands there.

I do want to mention our time constraints today. We are traveling back and we have a long journey ahead of us, so we are abbreviating our comments today and are actually going to replay that conversation that we had with Stephen Roach here recently, mainly because it crystallizes the key economic issues that have to be addressed, and many of those issues were, in fact, at least, nodded at, in the most recent 5-year plan, released in March of this year.

And of course, our subsequent interviews with some economic and political experts of China in which they have basically said, “It’s a great plan, now let’s see if they are going to do anything about it, or is it going to be just talk, talk, talk,” as Minxin Pei has suggested.

I look forward to be back in the United States, I look forward to being back in the office, and I look forward to talking to clients again. It has been a good four weeks away, both through Europe and through Asia, but the travel is about to be concluded and we will be working on the next DVD, which is a summary of our findings in Asia.

Again, if we have your email address, that is going to be the quickest way for us to get it to you, otherwise it will be a 6-8 week delay before a physical copy is available, so make sure that we have your email address and we will send you the second installment of this year’s film project. The first was on Europe, the second is now on Asia, and the third will be a post-election summary.

Kevin: Truly, David, I am looking forward to that coming out. In the meantime, with us replaying this Stephen Roach interview, we should probably let the listeners know that this was a couple of years ago when he was talking. This was before the next 5-year plan came out. Stephen Roach has been an expert on Asia for many years. He was with Morgan-Stanley at the time. I think he has left that position. He has retired from that position and holds an academic position at Yale University, isn’t that right?

David: That’s correct. He is in the Economics Department at Yale, and will continue to make a great contribution there. He writes regularly. His articles can be found here and there on the Internet – a fabulous thinker, very crystal clear, and lays out his views on Asia very well in this interview.

Kevin: I can say, David, this is one interview that you and I have listened to multiple times. I don’t think there has been another guest that we have had, based on Asia, that we have listened to more often, and really, still seems to be just as relevant today as it was a couple of years ago.

David: Stephen, your analysis is greatly appreciated. I miss your more frequent missives as the chief economist at Morgan. You have added gravity to much of my own thinking over the last ten years or so that I have read you with great frequency. I am interested in China for many reasons, not the least of which, that we have seen a gradual shift from Western power centers toward the East, and it has been a process that, over the last hundred years, has been in place, but greatly accelerated in the last 31 years. We have certain questions that remain unanswerable. What will the world look like 20, 50, or 100 years from now? But with curiosity, we look at the present landscape to see what trends might take hold and define the world we live in.

Our conversation today is directed toward your views of Asia, specifically China, as you have taken on significant responsibilities as Chairman of Morgan Stanley Asia. However, seeing the world as you do from a macro perspective, please draw on all relevant external factors, U.S. monetary policy, global central banking practices, Basel III, any other fiscal issues that might be in the background.

We look at The Next Asia. Your book is a book that explores the potential of Asia, the potential of China, looks at it very reasonably, in terms of the things that are in motion now that are very positive, but also the headwinds that, particularly, China faces as they are trying to break from older models. Why did you title it The Next Asia? Are we there yet? What would it take for us to see the world redefined in terms of leadership or influence by China?

Stephen Roach: Thank you for your fascinating questions, and your kind words in the introduction. If you look at China as emblematic of this region’s extraordinary dynamism, their record over the last 30 years has been nothing short of extraordinary – miraculous. You can’t come up with enough in the way of superlatives.

But if you bore into the numbers, two sectors, exports and fixed investment, have really accounted for the bulk of the miracle. These two sectors back in 1979 when the economy was on the brink of collapse post cultural revolution, at that point totaled about 34% of Chinese GDP, and at their peak in early 2007, had risen to about 75% of the economy.

The export sector was, by far, the biggest driver in terms of growth, but investment moved up a lot, too, and a lot of that investment was driven by construction of the export platform, the manufacturing capacity, the infrastructure, the supply chain logistics, and the like.

That model, as brilliant as it was, and it led to spectacular GDP growth, improvements in per capita income, dramatic reduction in poverty in China, is not enough to take China to the next stage, because it is heavily dependent on external demand, demand elsewhere in the world economy. This crisis is a wakeup call to China that external demand underpinnings, first in America, now in Europe, cannot be counted on to continue to drive the economy to the same type of growth going forward as it did in the past.

My thesis of The Next Asia is that Asia, led by China, has to now look inward in providing stimulus to its most precious assets, of 3½ billion consumers living in Asia, and 1.3 of them living in China. This is going to require tough policies, innovative policies, but a new approach to economic growth, for a region that has become heavily dependent on exporting its product to others. The Next Asia is all about that transition from the externally supported model to one that draws greater support from internal demand.

David: If the transition is critical, we can start with something we know well – the American consumer. How important is U.S. consumption to past, present, and future growth dynamics in Asia?

Stephen: It is ironic. The U.S. consumer – the population map in America is relatively small – 4½% of the world’s population. The U.S. consumer is a 10 trillion-dollar consumer, and the best way I know to compare it is to look at these large population masses in Asia – China and India combined – close to 40% of the world’s population, ten times the number of people, but the combined consumption is about $2½ trillion, or one quarter that in the U.S.

The U.S consumer really drives global consumption, and for export-led economies like China and India, is the mainstay, the anchor, the bulk of the external demand growth. The American consumer, and I should say, the excesses of the American consumer, have been hugely important in driving the external demand that underpins Chinese and other Asian exporters. What worries me a lot, actually, is that so much of the American consumption model was built on a false foundation of asset bubbles and credit bubbles and sharply reduced savings.

The question that Asians need to ask is, how much of their export-led growth dynamic became overly dependent on false consumption in the U.S.? Are Asian exporters guilty of really premising their growth models on the false pretenses of excess and unsustainable consumption in the U.S.? The crisis is telling Asians and others that are dependent on U.S. consumption that they may have gone too far in relying on this false model.

David: We are at the end of a significant credit boom, a 20-30 year, almost uninterrupted credit boom, and the growth that you describe in your book, 31 years, the real period of transition for China, 1979 to the present, did take place in the context of credit expansion globally, but particularly in the United States, where the consumer, as you say, may have overstretched and overreached in terms of consumption compared to income.

What does that mean for China? Can they actually make a transition toward being internally consumptive in the context of credit now contracting instead of expanding? Or is the central bank policy there in China enough to literally paper over the divergence in credit contraction globally, but perhaps not in China?

Stephen: Let me just state at the outset in answering your question that liquidity injections from central banks really can’t solve anything. All they can do is give you a window of time to adjust or to put in a downside against deflationary risk and bring crises to an end, or if there is an inflation problem and the monetary policy needs to be tight, they can address the excesses of overheated economies. But the big problems are structural. In the case of China, I think it requires a very different approach to stimulate internal private consumption.

That approach, I think, needs to address three key issues in the structure of the Chinese economy. Number one is excess savings. Chinese households save to excess. By one measure, the household savings rate in China was 27.5% in the year 2000, and according to the flow of funds statistics, 37.5% in the year 2008. This is a savings excess engendered by fear, by insecurity, and it was a huge increase in precautionary saving by Chinese families. They don’t have a social safety net, so to compensate for that, they need to invest heavily in social security, private pensions, unemployment insurance, medical insurance. If China does that, then I think some of that fear can be redressed, and the household savings rate could start to stabilize.

Secondly, China needs to address its lagging rural income problems. Over 800 million Chinese still live at relatively impoverished levels in the rural countryside, and their incomes have been lagging those in coastal China, in urban China. This is very much at odds with what the leaders of the Chinese Communist Party aspire to make a more egalitarian form, the so-called Harmonious Society, as it is referred to in China. To address this, you need policy to aggressively support rural incomes through tax rebates, through rural land reform, through IT-enabled connectivity of agricultural communities and through aggressive incentives to stimulate rural urban migration.

And finally, China needs new sources of job creation, and this is primarily going to take place in the services economy, stimulating labor-intensive service industries that are really far too small in China today, industries in the wholesale and retail trade area, leisure and hospitality, domestic transportation, supply chain logistics, finance, health care. If China does that, it can come up with new sources of job creation to also stimulate private purchasing power. These are all policies that China can accomplish and begin to move ahead on, I think, in a relatively short period of time.

David: It is interesting, you describe liquidity injections by central bankers as being only a temporary fix. Monetary authorities can create money, but they can’t necessarily direct its flow, and so we have these unstable thematics that develop on the other side of liquidity injections as asset bubbles are created. It seems to be the history of the U.S. It seems that there is a bubble forming in China as a result of most of the credit creation of the last year or two, maybe a few years more than that.

Going into urban construction, it is not really that widely dispersed. You just described three structural things that need to take place. Are they taking place? Is the social safety net being developed? How do you move toward a service-oriented economy? It took us 40-50 years to accomplish that here in the United States. Is that perhaps why you are describing it as The Next Asia? Not necessarily the Asia of today, but what needs to be, and what could be, a success story in Asia, but it is not our current context?

Stephen:The next Asia is very much premised on the transition from a system driven by external demand to one driven by internal demand, and the Chinese consumer is a critical piece in that equation. The general notion, when I talk about this around the world is that it is going to take a long, long time. I would say two things in response.

Number one: Because of the here and now of external demand shocks, China does not have a long, long time. They can’t afford to make this as drawn-out a process as the manufacturing-led development of the last 30 years was, unless they are prepared to take a major growth shortfall, arising from a weaker external growth environment.

Number Two: I have learned in the years I have been focusing on China, never to underestimate the determination of the Chinese authorities, and their still centrally planned economy, to push through dramatic change, and to accomplish tough objectives in short periods of time. China operates on the basis of a five-year planning cycle. The next five-year plan, which would be the twelfth five-year plan, is due to be enacted by the National People’s Congress in February of 2011. That is only nine months away. We will get some hints as to where they are headed by the end of this year. This will be the last five-year plan of the current leadership headed up by President Hu Jintao and Premier Wen Jiabao.

I do believe that this is going to be an aggressive five-year plan that does go after dealing with the excesses of saving, lagging rural incomes, and services-led job creation. I think there are pieces of this plan that could be accomplished in a short period of time, but I think the transition is going to have a long tail to it. The challenge for China is to move the needle away from external, toward internal, demand. I honestly do think that important progress in these areas can be accomplished in a short period of time.

Finally, I would say that, in response to the first point you made in addressing this question, yes, there is a property bubble in China. I don’t think it is a bubble in broad-based urban construction, though. I think it is concentrated in speculative activity in the high-end residential property market in ten major coastal cities. The Chinese government has taken aggressive administrative actions to deal with that. They have been pre-emptive compared to the way we approach this in the West.

In the West, we claim that we can’t do anything to address bubbles, and then we also claim, mistakenly, in my view, that we have the wisdom and the power to clean up the mess after these bubbles burst. Well, look at the mess that we have made in the West by following that approach. The Chinese are pre-emptive. They move quickly to address asset bubbles before they impact and distort the real economy. That is the difference between the Chinese approach and the American/Western approach. The Chinese economy is in much better shape than the bubble-distorted American economy was and is, and that is an important distinction in the way they conduct policy in this country.

David: As we look at the state of the external world, we are talking about a transition that needs to occur, a rebalancing of their GDP mix, and at this point, it is a challenge, as you say, because they need time, and that may be the one element that they don’t have. On top of that, we live in a very fragile financial state on a global basis. They are external-dependent today, and yet their source of funding, whether it is the U.S., whether it is Europe, to their larger trade blocks – we have our own issues. Maybe you can speak to the case for relapse in terms of financial crisis and economic crisis.

Stephen: When you come out of a crisis as severe as the one was in 2008 and 2009, history tells you that you are bound to have periodic aftershocks, and in my opinion, the sovereign debt crisis in Europe is really an aftershock of the subprime crisis of 2008 and 2009. There could be more aftershocks to come, we don’t know.

By definition, shocks are unexpected developments, but Southern Europe failed to really address its public sector deficit issues going into the crisis, and when the crisis came, and the revenue stream collapsed, the deficits went from bad to worse overnight. These are the types of developments that you can expect, unfortunately, in a post crisis climate. So there could be more, as I said.

The post crisis global economy is in a very fragile state right now, and that is a big issue that must be addressed, and I am not convinced that the world has taken the appropriate steps to deal with those issues. I think that is an important problem right now.

David: As we look at Washington, there has been a debate raging over the renminbi and the proper foreign currency valuation, or exchange rate, between the U.S. dollar and the renminbi. And it has been said, if only the Chinese would revalue. What seems odd to me is that on the other side of a major revaluation, couldn’t we find ourselves with a debt funding problem? Rebalancing looks to be positive for China, and perhaps negative for the U.S., as surplus dollars which have been used for the purchase of Treasuries diminish. I am wondering why we would press so far for renminbi revaluation when one of the unintended consequences ends up being a potential funding crisis for the U.S.

Stephen: You are exactly right. This is, unfortunately, a painfully classic example of bad politics driving bad economics. America has a serious problem. The main problem we have is a very high unemployment rate, not just 10%, as measured in the official data, but much higher than that, if you adjust the official data for people that have given up looking for work.

We want to blame others for our unemployment problem. In particular, we say that this would not have happened if we had not had a big trade deficit, and the biggest piece of our trade deficit with China, there are many academics and politicians who claim that China manipulates its currency, so let’s hold them responsible for the problems bearing down on the American middle class. This is emotionally appealing, and the polls suggest that it resonates with middle class American workers across the land.

Unfortunately, it’s just not borne out by analysis or fact. If you look at the United States and our trade deficit, it is enormous. There is no question about it. Over the last two years, however, we ran trade deficits with over 90 different countries, and we have a multilateral trade deficit, to use economic jargon, and we can’t fix that by forcing one country to make an adjustment in its bilateral currency rating. Yet there are politicians and leading economists, some of our Nobel prize-winning economists, who argue that the only way to resolve this is through forcing the Chinese to address the bilateral exchange rate between their currency, the renminbi, and the dollar.

This would not do anything. The reason we run a multilateral trade deficit with over 90 different countries is because we have a savings shortfall. We have the lowest savings rate of any leading economy in the history of modern world, and when you have a savings shortfall, you must run a massive current account deficit and multilateral trade imbalances to attract the capital. If you try to fix a multilateral imbalance by forcing an adjustment on a bilateral cross-rate, nothing happens. You just exchange the Chinese piece for a deficit with somebody else who is presumably a higher-cost producer who ends up taxing the same American worker you are trying to protect.

So this is a bogus problem, and it is unfortunate that it has become politicized and with great consequences because, as you said in your key premise, and I’m sorry to go on for so long, but this is a critical issue, China is going to move to a consumer-led society. They are going to absorb their surplus savings and have less of that to send our way to fund out excess consumption and our deficits in the United States. Who is going to pick up the slack if the Chinese won’t fund it? Have we thought about that? Have we thought about what that means for the dollar? Have we thought about what that means for long-term interest rates in the U.S.?

I don’t think our politicians and some of our lead economists have really thought this one through clearly. What they say when I raise this question with them at congressional testimony, or in debates with some of these academics is, “Well, what else are they going to do with their money?” I’ll tell you what else they are going to do with their money. They are going to invest it in their own infrastructure to support their internal private consumption, and before you know it, you are right, we will have a funding crisis of epic proportions, because we haven’t done what they have done. We have not taken the heavy lifting on structural change that we need to make our economy more balanced while they have gone ahead and done it. And then, what are we going to do?

David: If we are talking about what is the right model, we could explore what that looks like for China and India. We could also look at that from the U.S. perspective, because, as you say, we have major structural issues, ourselves, and they need to be addressed, whether it is aftershocks, or just recreating the same kinds of things that lend to the financial crisis in the first place. ING Direct is unveiling interest-only perpetual mortgages. I see that Kensington, a subdivision of Investec, is back issuing, they’re not calling it subprime, but what they are calling almost prime, loans. What are we doing? Have we learned nothing in the 2006 to present period, to really look at structural issues and address them at a most basic foundational level? What is the right model for us, as well as for them?

Stephen: I think you are right to ask about us, because I worry, as we sit here and preach what the right model is to China, through making changes in its currency, and dictating what the right approach to constructing a new economy is, that we have lost sight of what we need to do at home. I think we need to take a long, hard look in the mirror. I think there are two things that I would stress right off the bat that we need to address immediately, and that is, we need to rediscover the strategy that will turn us into long-term savers in America.

Whenever I say the word saving, I get criticized by so many of these high-profile academics who say, “He doesn’t know what he is talking about. We are a weak economy and if we save we will go into a depression.” I’m not saying we should save now, but I’m saying that we need to identify strategies over the long-term to convert America from a nation of excess consumers to a nation that puts aside saving to fund the retirement of 77 million baby boomers to rebuild our aging infrastructure and to have the wherewithal to invest in new technologies and innovation, the types of industries and companies that have made America great.

Our savings rate as a nation right now, if you add it up for consumers, for businesses, and the government sector, and then adjust out the portion of that saving that needs to go toward the replacement of a worn-out or antiquated capital stock, the net national savings rate (those are the words we use to describe what I just articulated) went negative in 2008 and in 2009 was a –2.5% of national income. No country, not America or anybody else, has had such a weak savings position, so we have to rebuild savings through deficit reduction, and by putting consumers on firmer footing.

The second thing we need to do is break ourselves from the habit of reckless, undisciplined, overly accommodative monetary policy. We have run very irresponsible monetary policy for a dozen years. Under Fed chairmen Bernanke and Greenspan, any time anything goes wrong in America, we just keep cutting interest rates, and when the equity bubble popped we put the federal funds rate down to 1%, and held it there too long and created monster bubbles in property and credit. Both Bernanke and Greenspan say that easy money had nothing to do with that. I think, with all due respect, they are completely wrong.

Now we have the subprime crisis and we didn’t have enough basis points to deal with that crisis, so now we have cut interest rates to zero, and we are holding them there for an extended period of time and we run the risk of creating the type of madness that you described may already be seeping back into market. We have set the cost of credit, the cost of risk, too low, and we have failed to save, and we have mismanaged our system, and we must learn those painful lessons before it happens again.

David: Rediscovering the strategy of becoming long-term savers – the only problem I see with that is that while I agree with you that it needs to happen, we have an internal intellectual bias amongst our policymakers, heavily influenced by Keynes, that savings is anathema. That is not something that you want to do. You want to turn over the national income as many times as possible and get people spending, spending, spending. So we do have to see an intellectual Renaissance if that is going to even become a part of the discussion, because if you are talking about the Ivy Leagues, or anyone in Washington or on Wall Street, it is a given that saving is unnecessary in this new and brave world of ours.

In terms of reckless monetary policy, is there a solution to reckless monetary policy short of a world where central bankers are either constrained, or don’t exist? Isn’t that really the case of monetary history, that when you give the keys to the kingdom away, they will be used as those authorities see fit, which becomes politicized, becomes reckless? Isn’t it almost a part of the system? Isn’t that why John Adams ended the second central bank?

I don’t want to bias the conversation here and assume that is the only solution, but how do you end reckless monetary policy? Now we have the whole world taking our lead and saying, “If it worked in the U.S. in the context of 2008 and 2009, it will work here.” A trillion dollars for Europe, we saw massive stimulus in China. It seems like the playbook is being distributed globally.

Stephen: First of all, the jury is out on whether it worked or not. This is the same broken approach that was tried in the aftermath of the equity bubble, and it did work. There were a lot of celebrations, and a lot of central bankers taking victory laps a few years after that strategy was deployed, because on the surface it appeared that it did work. But, of course, it did not, because it gave rise to an even frothier period of excess, and ended up distorting real economies, not just in the United States, but those around the world, as well as infecting banking systems around the world. I think it is premature to celebrate the success of any one of these post-crisis liquidity binges.

But you ask a deeper question, and that is, what can we do to address, in an honest, frank, intellectual way, this debate over savings? The lessons of Keynes tell us that in periods of economic distress, it is perfectly fine to run savings deficits to deal with the downside of economies. Keynes recommends deficit saving in perpetuity as a life support mechanism to sustain advanced developed economies. This is not the way to run any system. Who ends up picking up the tab? This is a massive intergenerational transfer that leaves some poor generation down the road with an enormous burden. John Maynard Keynes never prescribed that.

So what I am asking is that we begin to do something that we haven’t done in America in a long time, and that is, to lay out longer-term strategies and policies for governments, for central banks, even for businesspeople and individuals. While we recognize that, at a point of weakness in our economy, we cannot and should not be insisting that individuals and businesses and governments save immediately, we need to lay out a framework by which they begin to rediscover the art of saving over the longer haul. There is nothing in place right now that puts that debate in a medium to longer-term framework.

And finally, with respect to your point on monetary policy, we have been down this road before. It was back in the late 1970s when there was an equally similar consensus that central bankers were hopeless to deal with rampant double-digit inflation, that the costs would be so horrific on economies and on society, that this was a problem that was well beyond the scope of monetary policy.

One man proved that view wrong, and that is Paul Volcker. He came in as a fiercely independent central banker, very courageous, and took the Federal Funds Rate in the United States up to the unheard of level of 19% by mid-1981. That single, courageous act of public policy broke the back of inflation and ushered in a disinflation that was the single most important macro benefit to the United States economy of the last 30 years.

We can do it again. There is nothing wrong with monetary discipline, not taking the Federal Funds Rate up to a prohibitive level right now, but laying out a framework by which that Federal Funds Rate can move back to a more normal level at a point in time when the economy is capable of handling it. We need a blueprint for a normalization of monetary policy, and the sooner we get it, the better off we could be. I don’t buy the idea that we can’t do it, that we are hooked on zero interest rates in perpetuity. Look at Japan and what that has gotten them.

David: The key word you used there was independent. Volcker brought in something that was distanced from the body politic, and perhaps that is where China, in their 5-year strategy, carries an advantage in that they are not dealing with a 4-year or 2-year election cycle, where politicians are beholden to the next vote, and put a tremendous amount of pressure on the Fed to accommodate. Volcker stepped in and did something radical. Fortunately, we didn’t have a super-radical contingent in the United States to respond negatively to the recession that that 19% threw us into.

Alois Rašín in Czechoslovakia was murdered in 1923. He was assassinated for doing something similar, getting hold of inflation in the post war period. They didn’t like his policies so they just killed him. Volcker lived in a different era. We live in a different era, as well. Who is it that lays out that blueprint? I don’t know that it is Bernanke.

Stephen: I was working at the Federal Reserve in Washington in the late 1970s, and believe me, there was an outcry across the land when Volcker began his assault on inflation. Congressmen in both parties wanted his head. America’s farmers drove their fancy tractors in from Illinois, Iowa, Indiana, Nebraska and they blockaded the Federal Reserve building, they encircled it. They tried to prevent the Federal Reserve staff from going to work and continuing to squeeze the U.S. economy with high interest rates.

Volcker never flinched. Turns out there was another way he could get into the Federal Reserve building, he figured out how to do that, and did not flinch until the U.S. economy blinked and the back of inflation was broken. He also had a congress that, perhaps unwittingly, in 1978, by modifying the mandate of the Federal Reserve by passing what was known at the time as the Humphrey-Hawkins Act of 1978, adding price stability to the Fed’s official mandate, that gave him the political cover to do what he did.

And I have argued, though no one has listened, that that mandate, while it worked well for a while, is no longer sufficient to give a Fed chairman the political cover the likes of which Paul Volcker had to assault inflation. I think we need to modify the dual mandate of the Fed, which requires the U.S. Central Bank to focus on full employment and price stability, to now contain a third objective, and that is financial stability, so that whenever the system starts to go haywire, like it did in the last 12 years several times, the Fed has the political cover to step in and lean against excesses that end up distorting, not just the financial system, but also the real economy.

If we had that third leg to the policy mandate of the Fed in place, I think we would have a central bank that was more empowered to do the tough things that we need of an independent monetary authority that now do not seem to be in place. I have urged, repeatedly, the U.S. Congress to go down the road of, not just giving the Fed more power, as it is doing in this financial regulation, but requiring more accountability of the Fed, by also adding a financial stability mandate to its broad policy goals and objectives.

David: In theory, I would agree with that last point on financial stability. In practice, I am still scratching my head wondering who the people are involved who get that done. In our conversation a few months ago with Otmar Issing, he described an asymmetrical banking problem within the EMU, wherein they have done something very similar. They defend on the downside, but they don’t get ahead, aggressively, as the Chinese, as you have described, do, and try to prevent bubbles from developing to a full-fledged state.

Financial stability – yes. Greater accountability – yes. Who is it? And maybe there is no answer to that question, and in a time of crisis, new leadership emerges at just the right time, and we don’t necessarily know who that will be, or from what context they will come.

I just want to thank you for joining us today, and we look forward to perhaps continuing the conversation at a future date. You have added a tremendous amount to our understanding, and we appreciate your time, there from India.

Stephen: Thank you very much. I appreciate your comments and your questions. One last note, Dr. Issing is a good friend of mine. He has been a leading voice in Europe in trying to bring the financial stability debate into European monetary policy, and he has failed. I have tried to do the same thing in the U.S., and I have failed. I don’t think either one of us is going to give up.

David: We appreciate that, and we look forward to our future conversations as time goes on.